Weeding out the hype to find investments that are sound

We are in a period of profound change, driven by dynamic new technologies and a powerful pandemic economic recovery.

In times like this, it is natural for investors to look for investments that stand to benefit from these dramatic changes. But during investment booms like now, the search for sound investments is obscured by a haze of promotion and speculation. How do you then tell the difference between investment substance and hype?

While that’s not always easy to do, a broad framework called fundamental investing can help cut through the hype. Essentially, it involves basing investment decisions on a few basic factors that have proven helpful in achieving strong long-term investment results. That distinguishes it from speculative forms of investment that may involve pursuing a hot short-term trend.

“True investing is about understanding the fundamentals,” says John Stephenson, a prominent investment industry figure and currently an analyst, thematic research, at BMO Capital Markets.

The fundamentals can foster healthy skepticism to such heavily hyped speculative trends as cryptocurrencies, meme stocks, nonfungible tokens and special purpose acquisition companies (SPACs), to name a few. But the fundamentals can also help distinguish legitimate investment opportunities that can spring from many of today’s most promising emerging technologies.

Fundamental vs. speculation

Fundamental investors often think of themselves as investing in actual businesses rather than just investing in stocks. They generally invest for the long term and don’t try to just ride popular short-term trends. They strive for a deep understanding of the companies and management teams behind the investments. That includes carefully considering how technological and economic change might impact the company’s prospects, and weighing upside potential against risks to realizing that potential.

A key part of the fundamental approach is to do a careful financial valuation. Fundamental investors understand that investments in good companies can become bad investments if you pay too much.

Stock market analysts who follow a fundamental approach generally do a detailed financial analysis to assess individual stocks. Typically, this includes projecting the company’s future cash flows, then discounting those cash flows using the required rate of return to determine present value. That provides the basis for estimating the “intrinsic value” of what the stock should be worth. If you can buy the stock for less than intrinsic value, it should be a good deal. If the stock price is higher than intrinsic value, it appears overvalued.

Most average investors aren’t in a position to go into this level of detail, but they can get a rough-and-ready sense of whether a valuation makes sense or not. For example, they can compare the current market valuation of one stock to other stocks with similar business characteristics or to the market as a whole. In doing these comparisons, they use valuation metrics like the price-earnings (PE) ratio (stock price divided by earnings per share).

In stark contrast to fundamental investing is speculation. Its core shortcoming is that it lacks the relatively solid measuring stick of intrinsic value to use in making sound investment decisions. Speculation depends far more on investor sentiment, which is fickle and prone to sharp swings between optimism and pessimism.

Since investment booms tend to be accompanied and fuelled by hype, speculation often builds on itself and pays off well for a time. Stories abound of people making piles of money in hot investments, which entices new investors with fear of missing out (FOMO). But investment booms can turn quickly and unpredictably into sell-offs, and can occasionally become outright panics. All stock market investors are likely to suffer to a degree in a broad stock market downturn, but speculative investments tend to be particularly volatile and susceptible to bigger market plunges.

Hyping the trend

Here’s how a fundamental perspective can be applied to two of the most heavily hyped speculative trends, cryptocurrencies and meme stocks.

There are now more than 13,000 cryptocurrency offerings, ranging from whimsically dog-themed coins like Dogecoin and Shiba Inu to well-established market leaders like bitcoin. Unlike real currencies, cryptocurrencies are too cumbersome to be useful for day-to-day transactions. Crypto enthusiasts view them as “stores of value” similar to gold, but they lack the price stability that one would normally expect in that role.

The price for one bitcoin was around $60,000 early last week, but at times this year that price was under $40,000 (in January and July), and at other times over $75,000 (in spring and fall). Unlike stocks, there is no share in an underlying business that generates profits and cash flows, so fundamental investors can’t find a solid basis for valuing it or making money from it.

Meanwhile, in stock markets, speculation is rampant in specific areas. One new phenomenon is meme stocks, a motley grouping whose prices have been driven to stratospheric valuations by organized promotion from amateur investors on social media. They tend to see themselves as a populist movement battling hedge funds and Wall Street and aren’t much influenced by fundamentals.

One of the best-known meme stocks is AMC Entertainment Holdings Inc., a large movie theatre chain under intense pressure from in-home streaming services. The company lost money in 2019 even before the pandemic. With the added impact of pandemic restrictions and shutdowns, its stock price hit a low of $1.91 (U.S.) last January.

But soon after, it got caught up in the meme stock craze. Over a few months, the stock price grew 38 times, reaching a peak of $72.62 in June. Since then, the stock still has sizable social media support, but the stock price has nonetheless fallen back by more than half. It was trading around $30 early last week.

Meanwhile, the company is still losing money and facing tough competition from in-home movie viewing on streaming services, with no clear indication of reversing those trends. Considering the stock price reached a pre-pandemic low of $6.26 in February 2020, it’s tough to justify a stock price anywhere close to recent levels, even after the pandemic dissipates.

Scrutinizing growth

Fundamental investing can be particularly useful in sorting through growth or theme stocks and distinguishing those that represent credible opportunities from those that have been overhyped.

Of course, picking fundamental winners among growth stocks is harder than it sounds. Growth stocks often come with convincing stories of exciting new technologies that will generate explosive growth and fat profits, but that heady vision all too often fails to materialize. Still, despite the challenges, at least doing a careful fundamental analysis should increase your chances of making the right choices.

As an example of applying a fundamental process to growth stocks, one particular theme that Stephenson and his colleagues have been analyzing is the impact of autonomous vehicles and electrical vehicles on North American long-haul trucking. That research requires a thorough understanding of how those technologies are developing as well as the economics of trucking and how it competes with rail freight. “While we think it’s ultimately a game changer for that particular industry, we expect that’s ultimately eight or nine years away.”

You may wonder about the worth of trying to forecast an opportunity so far into the future, but that is a deliberate part of the process. “True theme investing is trying to catch the next thing before anyone else is looking,” Stephenson says. “There will probably be a point in time when the market catches up and then it becomes hyped and valuations get stretched. That’s the time you should be looking to leave,” he adds. “It’s very hard to make money on something that’s hype driven.”

Case in point for a heavily hyped growth investment is Tesla Inc., one of the pandemic’s hottest stocks. The price of Tesla stock hit a pre-pandemic peak of around $180 (U.S.) in February 2020, reached a high of $1,243 in November 2021, and has since settled back to around $900 early last week.

That represents a sky-high market value. The forward price-earnings (PE) ratio was around 146 early last week, compared with 22 for the S&P 500 U.S. stock index. Tesla’s valuation was also far higher than the other five largest U.S. tech stocks, which had forward PE ratios ranging from 24 to 66. (PE sources: Nasdaq, Zacks Investment Research, and Birinyi Associates.) When Tesla stock reached close to its price peak this fall, the Financial Times noted its market value exceeded that of the world’s nine next most valuable automobile manufacturers combined.

To fundamental investors, that raises a red flag. For Tesla to justify that high a valuation based on fundamentals requires a dramatic scenario of massive domination of the world automotive industry, and probably also requires dominance of related emerging industries like battery storage and autonomous vehicle services. It’s not impossible, but it’s certainly a huge stretch.

“One of the problems is the public falls in love with something and they jump on that,” says Stephenson. He notes that Tesla has a charismatic and visionary founder in Elon Musk, while the company has forged ahead as an early leader in electric car manufacturing.

But he says you need to look past superficial rationales and dig deep into the fundamentals. “Often it’s just, ‘I like EVs. I think everyone is going to have an EV. I’m going to buy the leader.’ But why? And why buy it here at this price, versus a year ago at a much lower price?”

David Aston, a freelance contributing columnist for the Star, is a personal finance and investment journalist. He has a chartered financial analyst designation and is a chartered professional accountant. Reach him via email: [email protected]